What is a Hedge Fund?

A hedge fund is an alternative investment vehicle available only to sophisticated investors, such as institutions and individuals with significant assets.

Like mutual funds, hedge funds are pools of underlying securities. Also like mutual funds, they can invest in many types of securities—but there are a number of differences between these two investment vehicles.

First, hedge funds are not currently regulated by the U.S. Securities and Exchange Commission (SEC), a financial industry oversight entity, as mutual funds are. However, it appears that regulation for hedge funds may be coming soon.

Second, as a result of being relatively unregulated, hedge funds can invest in a wider range of securities than mutual funds can. While many hedge funds do invest in traditional securities, such as stocks, bonds, commodities and real estate, they are best known for using more sophisticated (and risky) investments and techniques.

Hedge funds typically use long-short strategies, which invest in some balance of long positions (which means buying stocks) and short positions (which means selling stocks with borrowed money, then buying them back later when their price has, ideally, fallen).

Additionally, many hedge funds invest in “derivatives,” which are contracts to buy or sell another security at a specified price. You may have heard of futures and options; these are considered derivatives.

Many hedge funds also use an investment technique called leverage, which is essentially investing with borrowed money—a strategy that could significantly increase return potential, but also creates greater risk of loss. In fact, the name “hedge fund” is derived from the fact that hedge funds often seek to increase gains, and offset losses, by hedging their investments using a variety of sophisticated methods, including leverage.

Third, hedge funds are typically not as liquid as mutual funds, meaning it is more difficult to sell your shares. Mutual funds have a per-share price (called a net asset value) that is calculated each day, so you could sell your shares at any time. Most hedge funds, in contrast, seek to generate returns over a specific period of time called a “lockup period,” during which investors cannot sell their shares. (Private equity funds, which are similar to hedge funds, are even more illiquid; they tend to invest in startup companies, so investors can be locked in for years.)

Finally, hedge fund managers are typically compensated differently from mutual fund managers. Mutual fund managers are paid fees regardless of their funds’ performance. Hedge fund managers, in contrast, receive a percentage of the returns they earn for investors, in addition to earning a “management fee”, typically in the range of 1% to 4% of the net asset value of the fund. That is appealing to investors who are frustrated when they have to pay fees to a poorly performing mutual fund manager. On the down side, this compensation structure could lead hedge fund managers to invest aggressively to achieve higher returns—increasing investor risk.

As a result of these factors, hedge funds are typically open only to a limited range of investors.
Specifically, U.S. laws require that hedge fund investors be “accredited,” which means they must earn a minimum annual income, have a net worth of more than $1 million, and possess significant investment knowledge.

The popularity of these alternative investment vehicles—which were first created in 1949—has waxed and waned over the years. Hedge funds proliferated during the market boom earlier this decade, but in the wake of the 2007 and 2008 credit crisis, many closed. One, Bernard L. Madoff Investment Securities, turned out to be a massive fraud. As a result, they are subject to increasing due diligence.

Some of the more popular hedge fund investment strategies are Activist, Convertible Arbitrage, Emerging Markets, Equity Long Short, Fixed Income, Fund of Funds, Options Strategy, Statistical Arbitrage, and Macro.

Despite these recent challenges, hedge funds continue to offer investors a solid alternative to traditional investment funds—an alternative that brings the possibility of higher returns that are uncorrelated to the stock and bond markets. As a result, hedge funds are likely here to stay.